UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

For the Quarterly Period Ended November 30, 2003

 

or

 

 

Commission File No. 1-6263

 

 

AAR CORP.

(Exact name of registrant as specified in its charter)

 

 

(630) 227-2000

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  ý  No  o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes  ý  No  o

 

As of December 31, 2003, there were 32,046,273 shares of the registrant’s Common Stock, $1.00 par value per share, outstanding.

 

 

AAR CORP. and Subsidiaries

Quarterly Report on Form 10-Q

For the Quarter Ended November 30, 2003

Table of Contents

 

Part I – FINANCIAL INFORMATION
	Item 1.	Financial Statements
			Condensed Consolidated Balance Sheets
			Condensed Consolidated Statements of Operations
			Condensed Consolidated Statements of Cash Flows
			Condensed Consolidated Statements of Comprehensive Income
			Notes to Condensed Consolidated Financial Statements
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk
	Item 4.	Controls and Procedures
Part II – OTHER INFORMATION
	Item 4.	Submission of Matters to a Vote of Security Holders
	Item 6.	Exhibits and Reports on Form 8-K
			Exhibits
			Reports on Form 8-K
	Signature Page
	Exhibit Index

 

2

 

PART I, ITEM 1 – FINANCIAL STATEMENTS

 

AAR CORP. and Subsidiaries

Condensed Consolidated Balance Sheets

As of November 30, 2003 and May 31, 2003

(In thousands)

 

		November 30, 2003			May 31, 2003
		(Unaudited)			(Audited)
ASSETS
Current assets:
Cash and cash equivalents		$	39,198		$	29,154
Accounts receivable, less allowances of $7,696 and $8,663, respectively		66,769			66,322
Inventories		200,373			219,894
Equipment on or available for short-term lease		35,938			40,060
Deposits, prepaids and other		14,345			13,692
Deferred tax assets		27,142			27,290
Total current assets		383,765			396,412
Property, plant and equipment, net		83,836			94,029
Other assets:
Investments in leveraged leases		9,386			27,394
Goodwill, net		45,975			45,951
Equipment on long-term lease		86,029			72,732
Other		57,187			50,103
		198,577			196,180
		$	666,178		$	686,621

 

The accompanying Notes to Condensed Consolidated Financial

Statements are an integral part of these statements.

 

3

 

AAR CORP. and Subsidiaries

Condensed Consolidated Balance Sheets

As of November 30, 2003 and May 31, 2003

(In thousands except per share amounts)

 

		November 30, 2003			May 31, 2003
		(Unaudited)			(Audited)
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Short-term debt		$	5,940		$	24,000
Current maturities of long-term debt		6,374			24,000
Non-recourse debt		32,141			32,527
Notes payable		8,529			11,729
Accounts payable		54,251			51,485
Accrued liabilities		64,064			59,834
Accrued taxes on income		—			—
Total current liabilities		171,299			203,575
Long-term debt, less current maturities		167,499			164,658
Deferred tax liabilities		22,472			22,601
Retirement benefit obligation		799			799
Deferred income and other		9,288			—
		200,058			188,058
Stockholders’ equity:
Preferred stock, $1.00 par value, authorized 250 shares; none issued		—			—
Common stock, $1.00 par value, authorized 100,000 shares; issued 33,742 and 33,543 shares, respectively		33,742			33,543
Capital surplus		165,823			164,651
Retained earnings		142,192			143,272
Treasury stock, 1,697 and 1,692 shares at cost, respectively		(26,839		)	(26,798		)
Unearned restricted stock awards		(1,698		)	(514		)
Accumulated other comprehensive income (loss):
Cumulative translation adjustments		(2,477		)	(3,244		)
Minimum pension liability		(15,922		)	(15,922		)
		294,821			294,988
		$	666,178		$	686,621

 

The accompanying Notes to Condensed Consolidated Financial

Statements are an integral part of these statements.

 

4

 

AAR CORP. and Subsidiaries

Condensed Consolidated Statements of Operations

For the Three and Six Months Ended November 30, 2003 and 2002

(Unaudited)

(In thousands except per share amounts)

 

		Three Months Ended November 30,						Six Months Ended November 30,
		2003			2002			2003			2002
Sales:
Sales from products and leasing		$	133,918		$	131,389		$	264,956		$	261,984
Sales from services		25,601			21,662			46,677			42,232
		159,519			153,051			311,633			304,216
Costs and operating expenses:
Cost of products and leasing		113,161			112,084			226,164			226,687
Cost of services		21,228			18,037			39,223			36,834
Selling, general and administrative and other		19,502			19,443			39,150			40,224
		153,891			149,564			304,537			303,745
Operating income		5,628			3,487			7,096			471
Interest expense		(4,761		)	(4,883		)	(9,674		)	(9,750		)
Interest income		541			377			916			753
Income (loss) before provision for income taxes		1,408			(1,019		)	(1,662		)	(8,526		)
Provision (benefit) for income taxes		492			(356		)	(582		)	(2,984		)
Net income (loss)		$	916		$	(663	)	$	(1,080	)	$	(5,542	)
Income (loss) per share of common stock - basic		$	0.03		$	(0.02	)	$	(0.03	)	$	(0.17	)
Income (loss) per share of common stock - diluted		$	0.03		$	(0.02	)	$	(0.03	)	$	(0.17	)
Weighted average common shares outstanding - basic		31,979			31,844			31,915			31,855
Weighted average common shares outstanding - diluted		32,263			31,844			31,915			31,855
Dividends paid and declared per share of common stock		$	—		$	—		$	—		$	0.025

 

The accompanying Notes to Condensed Consolidated Financial

Statements are an integral part of these statements.

 

5

 

AAR CORP. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

For the Six Months Ended November 30, 2003 and 2002

(Unaudited)

(In thousands)

 

		Six Months Ended November 30,
		2003			2002
Cash flows from operating activities:
Net loss		$	(1,080	)	$	(5,542	)
Adjustments to reconcile net loss to net cash provided from operating activities:
Depreciation and amortization		13,167			14,142
Deferred taxes		19			(2,361		)
Changes in certain assets and liabilities:
Accounts and trade notes receivable		(3,489		)	1,064
Inventories		19,692			1,780
Equipment on or available for short-term lease		4,270			1,424
Equipment on long-term lease		480			405
Accounts and trade notes payable		2,732			10,759
Accrued liabilities and taxes on income		(95		)	(14,793		)
Other, primarily prepaids		(1,522		)	2,261
Net cash provided from operating activities		34,174			9,139
Cash flows from investing activities:
Property, plant and equipment expenditures		(4,382		)	(4,883		)
Proceeds from disposal of assets		27			59
Proceeds from sale of facilities, net		16,922			2,969
Investment in leveraged leases		400			837
Other		(906		)	(57		)
Net cash provided from (used in) investing activities		12,061			(1,075		)
Cash flows from financing activities:
Proceeds from borrowings		13,959			—
Reduction in borrowings		(49,385		)	(2,517		)
Financing costs		(827		)	—
Cash dividends		—			(796		)
Other		—			9
Net cash used in financing activities		(36,253		)	(3,304		)
Effect of exchange rate changes on cash		62			28
Increase in cash and cash equivalents		10,044			4,788
Cash and cash equivalents, beginning of period		29,154			34,522
Cash and cash equivalents, end of period		$	39,198		$	39,310

 

The accompanying Notes to Condensed Consolidated Financial

Statements are an integral part of these statements.

 

6

 

AAR CORP. and Subsidiaries

Condensed Consolidated Statements of Comprehensive Income

For the Three and Six Months Ended November 30, 2003 and 2002

(Unaudited)

(In thousands)

 

		Three Months Ended November 30,						Six Months Ended November 30,
		2003			2002			2003			2002
Net income (loss)		$	916		$	(663	)	$	(1,080	)	$	(5,542	)
Other comprehensive income - Foreign currency translation		3,357			313			767			2,271
Total comprehensive income (loss)		$	4,273		$	(350	)	$	(313	)	$	(3,271	)

 

The accompanying Notes to Condensed Consolidated Financial

Statements are an integral part of these statements.

 

7

 

AAR CORP. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

November 30, 2003

(Unaudited)

(In thousands)

 

Note A – Basis of Presentation

 

The accompanying condensed consolidated financial statements include the accounts of AAR CORP. and its subsidiaries (“the Company”) after elimination of intercompany accounts and transactions.

 

These statements have been prepared by the Company without audit, pursuant to the rules and regulations of the United States Securities and Exchange Commission (“SEC”).  The condensed consolidated balance sheet as of May 31, 2003 has been derived from audited financial statements.  To prepare the financial statements in conformity with accounting principles generally accepted in the United States of America, management has made a number of estimates and assumptions relating to the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities.  Actual results could differ from those estimates.  Certain information and note disclosures, normally included in comprehensive financial statements prepared in accordance with accounting principles generally accepted in the United States, have been condensed or omitted pursuant to such rules and regulations of the SEC.  These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s latest annual report on Form 10-K.

 

In the opinion of management of the Company, the condensed consolidated financial statements reflect all adjustments (which consist only of normal recurring adjustments) necessary to present fairly the condensed consolidated financial position of AAR CORP. and its subsidiaries as of November 30, 2003 and the condensed consolidated results of operations and comprehensive income for the three- and six-month periods ended November 30, 2003 and 2002, and the condensed consolidated cash flows for the six-month periods ended November 30, 2003 and 2002.  The results of operations for such interim periods are not necessarily indicative of the results for the full year.

 

Note B – Stock-Based Employee Compensation Plans

 

The Company accounts for its stock-based compensation plans under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations.  No stock-based employee compensation cost related to the Company’s stock option plans is reflected in net income, as each option granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant.

 

8

 

The following table illustrates the effect on net income (loss) and income (loss) per share if the Company had applied the fair value recognition provisions of Statement of Accounting Financial Standards (“SFAS”) No. 123 to the Company’s stock option plans (in thousands, except per share amounts).

 

			Three Months Ended November 30,						Six Months Ended November 30,
			2003			2002			2003			2002
Net income (loss) as reported			$	916		$	(663	)	$	(1,080	)	$	(5,542	)
Add:  Stock-based compensation expense included in net income (loss) as reported, net of tax			87			20			122			65
Deduct:  Total compensation expense determined under fair value method for all awards, net of tax			(676		)	(674		)	(1,394		)	(1,373		)
Pro forma net income (loss)			$	327		$	(1,317	)	$	(2,352	)	$	(6,850	)
Income (loss) per share – basic:	As reported		$	0.03		$	(0.02	)	$	(0.03	)	$	(0.17	)
	Pro forma		$	0.01		$	(0.04	)	$	(0.07	)	$	(0.22	)
Income (loss) per share – diluted:	As reported		$	0.03		$	(0.02	)	$	(0.03	)	$	(0.17	)
	Pro forma		$	0.01		$	(0.04	)	$	(0.07	)	$	(0.22	)

 

The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants in the first six months of 2003 and 2002:

 

		Six Months Ended November 30,
		2003		2002
Risk-free interest rate		3.1	%	2.5	%
Expected volatility of common stock		66.9	%	64.0	%
Dividend yield		0.0	%	1.6	%
Expected option term in years		4.0		4.0

 

Note C – New Accounting Standards

 

In May 2003, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.”  SFAS No. 150 establishes standards on the classification and measurement of certain financial instruments with characteristics of both liabilities and equity.  SFAS No. 150 was effective immediately for financial instruments entered into or modified after May 31, 2003, and otherwise was effective at the beginning of the first interim period beginning after June 15, 2003. The provisions of SFAS No. 150 have not had an effect on the consolidated financial statements because the Company has not issued financial instruments with characteristics of both liabilities and equity.

 

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Note D – Revenue Recognition

 

Sales and related cost of sales for product sales are recognized upon shipment of the product to the customer.  The Company’s standard terms and conditions provide that title passes to the customer when the product is shipped to the customer.  Service revenues and the related cost of services are generally recognized when customer-owned material is shipped back to the customer.  The Company has adopted this accounting policy because at the time the customer-owned material is shipped back to the customer, all services related to that material are complete as the Company’s service agreements generally do not require it to provide services at customer sites.  Furthermore, the serviced units are typically shipped to the customer immediately upon completion of the related services.  Sales and related cost of sales for certain long-term manufacturing contracts and for certain large airframe maintenance contracts are recognized by the percentage of completion method, based on the relationship of costs incurred to date to estimated total costs under the respective contracts.  Lease revenues are recognized as earned.  Income from monthly or quarterly rental payments is recorded in the pertinent period according to the lease agreement.  However, for leases that provide variable rents, the Company recognizes lease income on a straight-line basis.  In addition to a monthly lease rate, some engine leases require an additional rental amount based on the number of hours the engine is used in a particular month.  Lease income associated with these contingent rentals is recorded in the period in which actual usage is reported by the lessee to the Company, which is normally the month following the actual usage.

 

Note E – Impairment Charges

 

The components of the fiscal 2003 and fiscal 2002 impairment charges were as follows:

 

		For the Year Ended May 31,
		2003			2002
Engine and airframe parts		$	2,360		$	56,000
Whole engines		3,000			11,400
Loss accruals for engine operating leases		—			8,500
		$	5,360		$	75,900

 

Prior to September 11, 2001 the Company was executing its plan to reduce its investment in support of older generation aircraft in line with the commercial airlines’ scheduled retirement plans for these aircraft.  The events of September 11 caused a severe and sudden disruption in the commercial airline industry, which brought about a rapid acceleration of those retirement plans.  System-wide capacity was reduced by approximately 20%, and many airlines cancelled or deferred new aircraft deliveries.  Based on management’s assessment of these and other conditions, the Company in the second quarter ended November 30, 2001, reduced the value and provided loss accruals for certain of its inventories and engine leases which support older generation aircraft by $75,900, of which $57,900 was related to the Inventory and Logistic Services segment and $18,000 was related to the Aircraft and Engine Sales and Leasing segment.

 

The fiscal 2002 writedown for engine and airframe parts was determined by comparing the carrying value for inventory parts that support older generation aircraft to their net realizable value.  In determining net realizable value, the Company assigned estimated sales prices taking into consideration historical selling prices and demand, as well as anticipated demand.  The $11,400 writedown during fiscal 2002 for whole

 

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engines related to assets that are reported in the caption “Equipment on or available for short-term lease” and was determined by comparing the carrying value for each engine to an estimate of its undiscounted future cash flows.  In those instances where there was a shortfall, the impairment was measured by comparing the carrying value to an estimate of the asset’s fair market value.  The loss accruals for engine operating leases were determined by comparing the scheduled purchase option prices to the estimated fair value of such equipment.  In those instances where the scheduled purchase option price exceeded the estimated fair value, an accrual for the estimated loss was recorded.

 

During the fourth quarter of fiscal 2003, the Company recorded additional impairment charges related to certain engine and airframe parts and whole engines in the amount of $5,360.  The fiscal 2003 impairment charge was based upon an updated assessment of the net realizable values for certain engine and airframe parts and future undiscounted cash flows for whole engines.  Of the $5,360 impairment charge recorded during fiscal 2003, $2,360 related to the Inventory and Logistic Services segment and $3,000 related to the Aircraft and Engine Sales and Leasing segment.

 

A summary of the carrying value of impaired inventory and engines, after giving effect to the impairment charges recorded by the Company are as follows:

 

		November 30, 2003			May 31, 2003			November 30, 2001
Net impaired inventory and engines		$	52,700		$	56,240		$	89,600

 

Proceeds from sales of impaired inventory and engines for the six-month period ended November 30, 2003 and the twelve-month period ended May 31, 2003 were $4,100 and $12,100, respectively.

 

Note F – Inventory

 

		November 30, 2003			May 31, 2003
The summary of inventories is as follows:
Raw materials and parts		$	47,294		$	45,702
Work-in-process		18,929			22,604
Purchased aircraft, parts, engines and components held for sale		134,150			151,588
		$	200,373		$	219,894

 

Note G – Investment in Joint Ventures

 

The following table provides summarized joint venture financial information at November 30, 2003 and May 31, 2003.

 

		November 30, 2003			May 31, 2003
Total assets		$	37,338		$	39,244
Total non-recourse debt		34,485			36,028
Net assets of joint venture		$	2,853		$	3,216
AAR CORP.’s 50% equity interest in joint venture		$	1,427		$	1,608

 

The aircraft in the joint venture is currently on lease scheduled to expire in April 2004.  The joint venture partners are currently seeking a new lessee for the aircraft, and although lease rates for this type of aircraft have improved, the Company expects the new monthly lease rate to be less than the current monthly lease rate.  If the joint venture partners are unsuccessful

 

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in re-leasing the aircraft, the joint venture will return the aircraft to the lender and the Company will write-off its investment in the joint venture.

 

Note H – Supplemental Cash Flows Information

 

		Six Months Ended November 30,
		2003			2002
Interest paid		$	8,263		$	8,814
Income taxes paid		347			3,087
Income tax refunds received		911			325

 

Note I – Common Stock and Earnings per Share of Common Stock

 

The computation of basic earnings per share is based on the weighted average number of common shares outstanding during each period.  The computation of diluted earnings per share is based on the weighted average number of common shares outstanding during the period plus, when their effect is dilutive, incremental shares consisting of shares subject to stock options.

 

The following table provides a reconciliation of the computations of basic and diluted earnings per share information for the three- and six-month periods ended November 30, 2003 and 2002 (in thousands, except per share amounts):

 

		Three Months Ended November 30,						Six Months Ended November 30,
		2003			2002			2003			2002
Basic:
Net income (loss)		$	916		$	(663	)	$	(1,080	)	$	(5,542	)
Weighted average common shares outstanding		31,979			31,844			31,915			31,855
Income (loss) per share of common stock – basic		$	0.03		$	(0.02	)	$	(0.03	)	$	(0.17	)
Diluted:
Net income (loss)		$	916		$	(663	)	$	(1,080	)	$	(5,542	)
Weighted average common shares outstanding		31,979			31,844			31,915			31,855
Additional shares due to hypothetical exercise of stock options		284			—			—			—
Weighted average common shares outstanding – diluted		32,263			31,844			31,915			31,855
Income (loss) per share of common stock – diluted		$	0.03		$	(0.02	)	$	(0.03	)	$	(0.17	)

 

For the six-month periods ending November 30, 2003 and 2002, respectively, stock options to purchase 5,650 and 4,759 shares of common stock were outstanding, but were not included in the computation of diluted earnings per share because the exercise price of these options was greater than the average market price of the common shares.

 

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Common stock equivalents representing options to purchase 89 and 2 shares for the six-month periods ending November 30, 2003 and 2002, respectively, were not included in the computations of diluted earnings per share because to do so would have been antidilutive due to the net loss during the respective periods.

 

Note J – Mortgage Financing

 

On July 1, 2003, the Company completed an $11,000 financing secured by a mortgage on its Wood Dale, Illinois facility.  The term of the financing is five years utilizing a fifteen-year amortization with a LIBOR-based interest rate of no less than 6.25%.  The amount outstanding under this agreement was $10,858 at November 30, 2003.

 

Note K – Sale-Leaseback

 

On October 3, 2003, the Company entered into a sale-leaseback transaction whereby the Company sold and leased back a facility located in Garden City, New York.  The lease is classified as an operating lease in accordance with SFAS No. 13, “Accounting for Leases”.  Net proceeds from the sale of the facility were $13,991 and the cost and related accumulated depreciation of the facility of $9,472 and $4,595, respectively, have been removed from the balance sheet.  The gain realized of $9,114 on the sale has been deferred and is being amortized over the 20-year lease term in accordance with SFAS No. 13.  The deferred gain is included in the caption “Deferred income and other” on the Condensed Consolidated Balance Sheet.

 

Note L – Aviation Equipment Operating Leases

 

The Company from time to time leases aviation equipment (engines and aircraft) from lessors under arrangements that are classified by the Company as operating leases.  The Company may also sublease the aviation equipment to a customer on a short- or long-term basis.  The terms of the operating leases in which the Company is the lessee are one year with options to renew annually at the election of the Company.  If the Company elects not to renew a lease or the lease term expires, the Company will purchase the equipment from the lessor at its scheduled purchase option price.  The terms of the lease agreements also allow the Company to purchase the equipment at any time during a lease at its scheduled purchase option price.

 

In those instances in which the Company anticipates that it will purchase aviation equipment and that the scheduled purchase option price will exceed the fair value of such equipment, the Company records an accrual for loss.  The scheduled purchase option values amounted to $32,763 at November 30, 2003 and $33,783 at May 31, 2003.

 

Note M – Segment Reporting

 

The Company is a leading provider of value-added products and services to the global aviation/aerospace industry.  The Company reports its activities in four business segments: Inventory and Logistic Services; Maintenance, Repair and Overhaul; Manufacturing; and Aircraft and Engine Sales and Leasing.

 

Sales in the Inventory and Logistic Services segment are derived from the sale of a wide variety of new, overhauled and repaired engine and airframe parts and components to the commercial aviation and military markets, as well as the distribution of new airframe parts purchased from various original equipment manufacturers and sold to commercial and general aviation customers.  Cost of sales consists

 

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principally of the cost of product (primarily aircraft and engine parts) and overhead (primarily indirect labor, facility cost and insurance).

 

Sales in the Maintenance, Repair and Overhaul segment are derived from the repair and overhaul of a wide range of commercial and military aircraft engine and airframe parts, landing gear and components; aircraft maintenance and storage; and the repair, overhaul and sale of parts for industrial gas and steam turbine operators.  Cost of sales consists principally of cost of product (primarily replacement aircraft parts), direct labor and overhead.

 

Sales in the Manufacturing segment are derived from the manufacture and sale of a wide array of containers, pallets and shelters used to support the U.S. Military’s tactical deployment requirements, in-plane cargo loading and handling systems for commercial and military applications and advanced composite materials and components for aerospace and industrial use.  Cost of sales consists principally of the cost of product, direct labor and overhead.

 

Sales in the Aircraft and Engine Sales and Leasing segment are derived from the sale and lease of commercial aircraft and engines and technical and advisory services.  Cost of sales consists principally of cost of product (aircraft and engines), labor and the cost of lease revenue (primarily depreciation, lease expense and insurance).

 

The accounting policies for the segments are the same as those for the Company.  The chief decision making officer (Chief Executive Officer) of the Company evaluates performance based on the reportable segments.  The expenses and assets related to corporate activities are not allocated to the segments.

 

Gross profit is calculated by subtracting cost of sales from sales.  Selected financial information for each reportable segment is as follows:

 

		Three Months Ended November 30,						Six Months Ended November 30,
		2003			2002			2003			2002
Sales:
Inventory and Logistic Services		$	69,257		$	65,198		$	130,994		$	126,497
Maintenance, Repair and Overhaul		53,000			52,388			106,425			99,314
Manufacturing		31,796			29,316			56,966			57,303
Aircraft and Engine Sales and Leasing		5,466			6,149			17,248			21,102
		$	159,519		$	153,051		$	311,633		$	304,216

 

		Three Months Ended November 30,						Six Months Ended November 30,
		2003			2002			2003			2002
Gross profit:
Inventory and Logistic Services		$	11,693		$	9,126		$	20,155		$	16,767
Maintenance, Repair and Overhaul		6,742			7,471			12,642			13,074
Manufacturing		5,847			5,058			9,615			8,146
Aircraft and Engine Sales and Leasing		848			1,275			3,834			2,708
		$	25,130		$	22,930		$	46,246		$	40,695

 

14

 

PART 1, ITEM 2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

AAR CORP. and Subsidiaries

Results of Operations

(In thousands)

 

Factors Which May Affect Future Results

 

The Company’s future operating results and financial position may be adversely affected or fluctuate substantially on a quarterly basis as a result of continuing difficulties in the commercial aviation environment, a relatively weak worldwide economic climate and other factors, including:  (1) a decline in demand for the Company’s products and services and the ability of the Company’s customers to meet their financial obligations to the Company, particularly in light of the weakened financial condition of many of the world’s commercial airlines; (2) the potential risk for declining market values for aviation products and equipment caused by various factors, including airline bankruptcies and other factors within the airline industry; (3) difficulties in re-leasing or selling aircraft and engines that are currently being leased on a long- or short-term basis; (4) lack of assurance that sales to the U.S. Government, its agencies and its contractors (which were 28.1% of total sales in fiscal 2003), will continue at levels previously experienced, since such sales are subject to competitive bidding and government funding; (5) access to the debt and equity capital markets and the ability to draw down under financing agreements, which may be limited in light of industry conditions and Company performance; (6) changes in or noncompliance with laws and regulations that may affect certain of the Company’s aviation related activities that are subject to licensing, certification and other regulatory requirements imposed by the FAA and other regulatory agencies, both domestic and foreign; (7) competition from other companies, including original equipment manufacturers, some of which have greater financial resources than the Company; (8) exposure to product liability and property claims that may be in excess of the Company’s substantial liability insurance coverage; (9) difficulties in being able to successfully integrate business acquisitions; and (10) the outcome of any pending or future material litigation or environmental proceedings.

 

Critical Accounting Policies

 

The Company’s condensed consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States.  Management of the Company has made estimates and assumptions relating to the reporting of assets and liabilities and the disclosures of contingent liabilities to prepare the condensed consolidated financial statements.  The most significant estimates made by management of the Company include adjustments to reduce the value of inventories and equipment on or available for lease, allowance for doubtful accounts and loss accruals for aviation equipment operating leases.  Actual results could differ materially from these estimates.  The following is a summary of the accounting policies considered critical by management of the Company.

 

Allowance for Doubtful Accounts  The Company’s allowance for doubtful accounts is intended to reduce the value of customer accounts receivable to amounts expected to be collected.  In determining the required allowance, the Company considers factors such as general and industry-specific economic conditions, customer credit history, and the customer’s current and expected future financial performance.

 

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Inventories  Inventories are valued at the lower of cost or market.  Cost is determined by the specific identification, average cost or first-in, first-out methods.  Provisions are made for excess and obsolete inventories and inventories that have been impaired as a result of industry conditions.  The Company has applied certain assumptions when determining the market value of inventories, such as historical sales of inventory, current and expected future aviation usage trends, replacement values and expected future demand.  Principally as a result of the terrorist attacks of September 11, 2001 and their impact on the global airline industry’s financial condition, fleet size and aircraft utilization, the Company recorded a significant charge for impaired inventories during the second quarter of fiscal 2002 utilizing those assumptions.  During the fourth quarter of fiscal 2003, the Company recorded an additional charge as a result of a further decline in market value for these inventories.  Reductions in demand for certain of the Company’s inventories or declining market values, as well as differences between actual results and the assumptions utilized by the Company when determining the market value of its inventories, could result in additional impairment charges in future periods.

 

Equipment on or Available for Lease  Lease revenue is recognized as earned.  The cost of the asset under lease is original purchase price plus overhaul costs.  Depreciation is computed using the straight-line method over the estimated service life of the equipment, and maintenance costs are expensed as incurred.  The balance sheet classification is based on the lease term, with fixed-term leases less than twelve months classified as short-term and all others classified as long-term.

 

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets,” the Company is required to test for impairment of long-lived assets whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable from its undiscounted cash flows.  When applying the provisions of SFAS No. 144 to equipment on or available for lease, the Company has applied certain assumptions when estimating future undiscounted cash flows, such as current and estimated future lease rates, estimated residual values and expected future demand.  Differences between actual results and the assumptions utilized by the Company when determining undiscounted cash flows could result in future impairments of equipment on or available for lease.

 

Aviation Equipment Operating Leases  The Company from time to time leases aviation equipment (engines and aircraft) from lessors under arrangements that are classified by the Company as operating leases.  The Company may also sublease the aviation equipment to a customer on a short- or long-term basis.  The terms of the operating leases in which the Company is the lessee are one year with options to renew annually at the election of the Company.  If the Company elects not to renew a lease or the lease term expires, the Company will purchase the equipment from the lessor at its scheduled purchase option price.  The terms of the lease agreements also allow the Company to purchase the equipment at any time during a lease at its scheduled purchase option price.  In those instances in which the Company anticipates that it will purchase aviation equipment and that the scheduled purchase option price will exceed estimated undiscounted cash flows related to the equipment, the Company records an accrual for loss.  The Company has applied certain assumptions when estimating future undiscounted cash flows, such as current and estimated future lease rates, estimated residual values, and expected future demand.  Differences between actual results and the assumptions utilized by the Company when determining undiscounted cash flows could result in future provisions for losses on aviation equipment under operating leases.

 

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Results of Operations – Three- and Six-Month Periods Ended November 30, 2003

(as compared with the same period of the prior year)

 

The Company reports its activities in four business segments: Inventory and Logistic Services; Maintenance, Repair and Overhaul; Manufacturing; and Aircraft and Engine Sales and Leasing.

 

Sales in the Inventory and Logistic Services segment are derived from the sale of a wide variety of new, overhauled and repaired engine and airframe parts and components to the commercial aviation and military markets, as well as the distribution of new airframe parts purchased from various original equipment manufacturers and sold to commercial and general aviation customers.  Cost of sales consists principally of the cost of product (primarily aircraft and engine parts) and overhead (primarily indirect labor, facility cost and insurance).

 

Sales in the Maintenance, Repair and Overhaul segment are derived from the repair and overhaul of a wide range of commercial and military aircraft engine and airframe parts, landing gear and components; aircraft maintenance and storage; and the repair, overhaul and sale of parts for industrial gas and steam turbine operators.  Cost of sales consists principally of cost of product (primarily replacement aircraft parts), direct labor and overhead.

 

Sales in the Manufacturing segment are derived from the manufacture and sale of a wide array of containers, pallets and shelters used to support the U.S. Military’s tactical deployment requirements, in-plane cargo loading and handling systems for commercial and military applications and advanced composite materials and components for aerospace and industrial use.  Cost of sales consists principally of the cost of product, direct labor and overhead.

 

Sales in the Aircraft and Engine Sales and Leasing segment are derived from the sale and lease of commercial aircraft and engines and technical and advisory services.  Cost of sales consists principally of cost of product (aircraft and engines), labor and the cost of lease revenue (primarily depreciation, lease expense and insurance).

 

The table below sets forth consolidated sales for the Company’s four business segments for the three- and six-month periods ended November 30, 2003 and 2002.

 

		Three Months Ended November 30,						Six Months Ended November 30,
		2003			2002			2003			2002
Sales:
Inventory and Logistic Services		$	69,257		$	65,198		$	130,994		$	126,497
Maintenance, Repair and Overhaul		53,000			52,388			106,425			99,314
Manufacturing		31,796			29,316			56,966			57,303
Aircraft and Engine Sales and Leasing		5,466			6,149			17,248			21,102
		$	159,519		$	153,051		$	311,633		$	304,216

 

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Three-Month Period Ended November 30, 2003

(as compared with the same period of the prior year)

 

Consolidated sales for the second quarter ended November 30, 2003 increased $6,468 or 4.2% over the same period in the prior year.  The sales increase is primarily concentrated in two reporting segments as the Company experienced increased demand for logistics support services from government customers and higher sales to airline customers in the Inventory and Logistic Services segment and continued strong demand for manufactured products that support the U.S. Military’s tactical deployment requirements in the Company’s Manufacturing segment.  Total sales to the U.S. and foreign governments and their contractors for the three-month period ended November 30, 2003 were $57,345, an increase of 21.8% compared to the prior year and represents 35.9% of consolidated sales for the three-month period ended November 30, 2003.

 

In the Inventory and Logistic Services segment, sales increased $4,059 or 6.2% compared to the prior year period.  The increase in sales is primarily attributable to continued strong demand for logistics support services from government customers and higher sales of engine parts supporting the Company’s airline customers.  During the second quarter the Company experienced lower new parts distribution sales to its general aviation customers.

 

Sales in the Maintenance, Repair and Overhaul segment increased $612 or 1.2% compared to prior year driven primarily by increased sales at the Company’s airframe maintenance facility.  The Company experienced lower sales at certain of its component repair facilities due to weak demand for these services.

 

In the Manufacturing segment, sales increased $2,480 or 8.5% compared to the prior year period principally due to continued strong demand for manufactured products that support the U.S. Military’s tactical deployment requirements and higher sales of cargo systems due to new contract awards.  During the second quarter of this fiscal year, the Company experienced lower sales of its non-aviation composite structure products.

 

In the Aircraft and Engine Sales and Leasing segment, sales decreased $683 or 11.1% compared to the prior year period primarily due to lower lease revenues of aircraft and engines.

 

Consolidated gross profit increased $2,200 or 9.6% over the prior year period primarily due to increased sales and an increase in the gross profit margin to 15.8% compared to 15.0% in the prior year. The gross margin percentage increased in the Inventory and Logistic Services and Manufacturing segments primarily due to the mix of products and services sold and increased volume.

 

Operating income improved by $2,141 or 61.4% over the prior year period as a result of increased gross profit.   The Company’s selling, general and administrative costs were essentially flat compared with the prior year.  Selling, general and administrative and other costs for the three-month period ended November 30, 2003 includes a provision for a customer allowance of $1,335, as well as an $836 gain recorded from the sale of a facility in Holtsville, New York.  Interest expense decreased $122 or 2.5% and interest income increased $164 or 43.5%, primarily as a result of an increase in average cash invested during the three-month period ended November 30, 2003 compared with the prior year period.

 

The Company reported consolidated net income of $916 compared to a consolidated net loss of $663 in the prior year as a result of the factors discussed above.

 

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Six-Month Period Ended November 30, 2003

(as compared with the same period of the prior year)

 

Consolidated sales for the six-month period ended November 30, 2003 increased $7,417 or 2.4% over the same period in the prior year.

 

In the Inventory and Logistic Services segment, sales increased $4,497 or 3.6% compared to the prior year period.  The increase in sales is principally attributable to increased demand for engine parts and higher sales to the U.S. Military for spares and logistics support.  Offsetting these increases were reductions in airframe part sales and lower sales to general aviation customers in the Company’s distribution unit.

 

Sales in the Maintenance, Repair and Overhaul segment increased $7,111 or 7.2% compared to the same period in the prior year primarily due to higher sales of aircraft maintenance services and industrial turbine engine overhaul and parts supply services, partially offset by lower demand for landing gear overhaul services.

 

In the Manufacturing segment, sales decreased $337 or 0.6% compared to the prior year period principally due to lower sales of the Company’s non-aviation composite structure products and cargo loading systems.  During the six-month period ended November 30, 2003, the Company experienced increased sales as a result of continued strong demand for its manufactured products supporting the U.S. Military’s tactical deployment activities.

 

In the Aircraft and Engine Sales and Leasing segment, sales decreased $3,854 or 18.3% as a result of lower engine sales partially offset by increased aircraft sales as a result of a narrow body aircraft sale during the period ended August 31, 2003.

 

Total sales to the U.S. and foreign governments and their contractors for the six-month period ended November 30, 2003 were $108,125, an increase of 21.5% compared to the prior year and represents 34.7% of consolidated sales for the six-month period ended November 30, 2003.

 

Consolidated gross profit increased $5,551 or 13.6% over the prior year period primarily due to increased sales and an increase in the gross profit margin to 14.8% compared to 13.4% in the prior year. The gross margin percentage increased in the Inventory and Logistic Services and Manufacturing segments primarily due to the mix of products and services sold and increased volume.

 

Operating income improved by $6,625 from the prior year period as a result of increased gross profit and lower selling, general and administrative expenses.  The Company reduced its selling, general and administrative costs by $1,074 or 2.7% compared to the same period in the prior year primarily as a result of reduced discretionary spending.  Selling, general and administrative and other costs for the six-month period ended November 30, 2003 includes a provision for a customer allowance of $1,335, as well as an $836 gain recorded from the sale of a facility in Holtsville, New York.  Interest expense decreased $76 or 0.8%; interest income increased $163 or 21.6%, primarily as a result of an increase in average cash invested during the six-month period ended November 30, 2003 compared with the prior year period.

 

The Company reported consolidated net loss of $1,080 compared to a consolidated net loss of $5,542 in the prior year as a result of the factors discussed above.

 

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Liquidity and Capital Resources

(as compared with May 31, 2003)

 

Historically, the Company has funded its growth, met contractual commitments and paid dividends through the generation of cash from operations, augmented by the periodic issuance of common stock and debt to the public and private markets.  The Company also relies on various secured credit arrangements, which currently include an accounts receivable securitization program, a secured revolving credit facility and certain aviation equipment operating leases to provide additional liquidity.  The Company’s continuing ability to borrow from its lenders and issue debt and equity securities in the future may be negatively affected by a number of factors, including general economic conditions, airline and aviation industry conditions, Company performance and geopolitical events, including the war on terrorism.  The Company’s ability to use its accounts receivable securitization program, revolving credit facility and aviation equipment operating leases is also dependent on those factors.  The Company’s ability to generate cash from operations is influenced primarily by the operating performance of the Company and working capital management.

 

At November 30, 2003, the Company’s liquidity and capital resources included cash of $39,198 and working capital of $212,466.  As of November 30, 2003, $6,350 of cash was restricted to support letters of credit.  At November 30, 2003, the Company had $35,000 available under its accounts receivable securitization program, all of which was outstanding.  The amount available under this agreement is based on a formula of qualifying accounts receivable. At November 30, 2003, the Company had $26,482 available under its secured revolving credit facility, of which $4,000 was outstanding.  The amount available under the revolving credit facility is also based on a formula of qualifying assets.

 

At November 30, 2003, the Company’s ratio of long-term debt to capitalization was 36.2%; up slightly from 35.8% at May 31, 2003, and at November 30, 2003 the Company’s ratio of total debt to capitalization was 42.8% compared to 46.6% at May 31, 2003.  The increase in the long-term debt to capitalization ratio compared to May 31, 2003 is primarily attributable to the Company’s $11,000 financing secured by a mortgage on its Wood Dale, Illinois facility. The mortgage financing was completed on July 1, 2003.  The decrease in the total debt to capitalization ratio compared to May 31, 2003 is principally due to the payment of $22,600 to retire the Company’s 7¼% Notes that matured on October 15, 2003.  The Company also has a universal shelf registration on file with the Securities and Exchange Commission under which, subject to market conditions, up to $163,675 of common stock, preferred stock or medium- or long-term debt securities may be issued or sold.

 

On October 3, 2003, the Company entered into a sale-leaseback transaction whereby the Company sold and leased back a facility in Garden City, New York.  Net proceeds from the sale were $13,991 and were used in part to reduce the Company’s outstanding borrowings (See Note K).

 

On October 15, 2003, the Company’s 7¼% Notes matured and were retired utilizing proceeds from the sale-leaseback transaction and cash on hand.  The outstanding balance of the Notes at the time of maturity was $22,600.

 

The Company continues to evaluate a number of financing alternatives that would allow the Company to improve its liquidity position and to finance future growth on commercially reasonable terms.  The Company’s ability to obtain additional financing is dependent upon a number of factors, including the geopolitical environment, general economic conditions, airline industry conditions, the operating performance of the Company and market conditions in the public and private debt and equity markets.

 

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On April 18, 2003, Standard and Poor’s downgraded the senior unsecured debt rating to BB minus from BBB minus with an outlook rating of negative.  On July 18, 2003, Fitch Ratings downgraded the unsecured debt rating to BB minus from BB plus and revised the outlook rating to negative from stable.  On August 5, 2003, Moody’s Investors Service downgraded the senior unsecured debt rating of the Company to B2 from B1.  The Company was removed from credit watch following the downgrade actions by each of the respective rating agencies.

 

In January 2004, the Company’s non-recourse notes of $32,141 mature and therefore have been classified as current on the November 30, 2003 Condensed Consolidated Balance Sheet.  The Company and the lender have signed a letter of intent to extend the maturity date of the non-recourse notes to August 2005.  As of November 30, 2003, the Company's equity investment in this aircraft was $2,537.

 

During the six-month period ended November 30, 2003, the Company generated $34,174 of cash from operations primarily due to a reduction in working capital and $13,167 of non-cash depreciation and amortization.  The improvement in working capital is principally attributable to a decrease in inventories of $19,692 and equipment on short-term lease of $4,270.

 

During the six-month period ended November 30, 2003, cash provided from investing activities was $12,061 consisting primarily of proceeds from the sale and leaseback of its Garden City, New York facility in the amount of $13,991 and proceeds from the sale of its Holtsville, New York facility in the amount of $2,931, partially offset by capital expenditures of $4,382.

 

During the six-month period ended November 30, 2003, the Company’s financing activities used $36,253 of cash reflecting the payment of $22,600 to retire the Company’s 7¼% Notes which matured on October, 15, 2003, the $20,000 paydown of the Merrill Lynch secured credit facility and reductions in other borrowings of $6,785.  Cash proceeds from financing activities include the $11,000 financing secured by a mortgage on the Wood Dale, Illinois facility, and additional proceeds from borrowings of $2,959.

 

21

 

A summary of long-term debt, bank borrowings, non-cancelable operating lease commitments for aviation equipment and accounts receivable securitization as of November 30, 2003 is as follows:

 

		Payments Due by Period
		Total			11/30/04			11/30/05			11/30/06			11/30/07			11/30/08			After 11/30/08
On Balance Sheet:
Debt		$	182,402		$	14,899		$	15,238		$	6,446		$	852		$	88,014		$	56,953
Non-recourse Debt		32,141			32,141			—			—			—			—			—
Bank Borrowings		5,940			1,940			—			4,000			—			—			—
Off Balance Sheet:
Aviation Equipment Operating Leases		32,763			9,521			8,323			14,919			—			—			—
Accounts Receivable Securitization Program		35,000			35,000			—			—			—			—			—

 

Notes:

 

(1)          The secured revolving credit facility expires May 28, 2006, and therefore the outstanding balance of $4,000 at November 30, 2003 has been reported as a payment due by 11/30/06 on the Bank Borrowings line.

 

(2)          The term of the accounts receivable securitization program with LaSalle is one year and therefore has been reported as a payment due by 11/30/04.  The Company expects to extend this program subject to approval by LaSalle.

 

(3)          The Company routinely issues letters of credit, performance bonds or credit guarantees in the ordinary course of its business.  These instruments are typically issued in conjunction with insurance contracts or other business requirements.  The total of these instruments outstanding at November 30, 2003 was approximately $10,234.

 

Forward-Looking Statements

 

This report contains certain forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995.  These forward-looking statements are based on beliefs of Company management, as well as assumptions and estimates based on information available to the Company as of the dates such assumptions and estimates are made, and are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or those anticipated, depending on a variety of factors, including those factors discussed under this Item 2 entitled “Factors Which May Affect Future Results”.  Should one or more of those risks or uncertainties materialize adversely, or should underlying assumptions or estimates prove incorrect, actual results may vary materially from those described.  Those events and uncertainties are difficult or impossible to predict accurately and many are beyond the Company’s control.  The Company assumes no obligation to publicly release the result of any

 

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revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

 

PART I, ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

The Company’s exposure to market risk includes fluctuating interest rates under its bank credit agreements and foreign exchange rates.  During the six-month periods ended November 30, 2003 and 2002, the Company did not utilize derivative financial instruments to offset these risks.

 

At November 30, 2003, $26,482 was available to the Company and $4,000 was outstanding under the secured revolving credit facility with Merrill Lynch Capital.  Interest on amounts borrowed under this credit facility is LIBOR based.  A hypothetical 10 percent increase to the average interest rate under this credit facility applied to the average outstanding balance during the six-month period ended November 30, 2003 would not have had a material impact on the financial position or results of operations of the Company.

 

Revenues and expenses of the Company’s foreign operations are translated at average exchange rates during the period, and balance sheet accounts are translated at period-end exchange rates.  Balance sheet translation adjustments are excluded from the results of operations and are recorded in stockholders’ equity as a component of accumulated other comprehensive income (loss).  A hypothetical 10 percent devaluation of foreign currencies against the U.S. dollar would not have had a material impact on the financial position or results of operations of the Company.

 

PART I, ITEM 4 – CONTROLS AND PROCEDURES

 

As of the end of the period covered by this report, the chief executive officer and chief financial officer of the Company evaluated the effectiveness of the Company’s disclosure controls and procedures and concluded that the Company’s disclosure controls and procedures effectively ensure that the information required to be disclosed in the reports that are filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported in a timely manner.

 

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AAR CORP. and Subsidiaries

November 30, 2003

 

PART II – OTHER INFORMATION

 

Item 4.             Submission of Matters to a Vote of Security Holders

 

The Annual Meeting of Stockholders of the Company was held on October 8, 2003.  The following item was acted upon at the meeting.

 

1)              Election of three Class I directors to serve until the 2006 Annual Meeting of Stockholders.  Three directors were nominated and elected by the stockholders by the requisite vote.

 

Directors Nominated and Elected at the Meeting
		Votes For		Votes Withheld
James G. Brocksmith, Jr.		25,675,760		3,595,958
Joel D. Spungin		25,678,652		3,593,066
David P. Storch		25,677,757		3,593,961
Continuing Directors
A. Robert Abboud
Ira A. Eichner
Ronald R. Fogleman
James E. Goodwin
Marc J. Walfish

 

Item 6.             Exhibits and Reports on Form 8-K

 

1)              Exhibits

 

The exhibits to this report are listed on the Exhibit Index included elsewhere herein.

 

2)              Reports on Form 8-K for Quarter ended November 30, 2003

 

On September 17, 2003, AAR CORP. filed a current report on Form 8-K reporting under Item 12 that it had issued a press release announcing financial results for the first fiscal quarter ended August 31, 2003.

 

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SIGNATURE

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

			AAR CORP.
			(Registrant)
Date:	January 14, 2004		/s/ TIMOTHY J. ROMENESKO
			Timothy J. Romenesko
			Vice President and Chief Financial Officer
			(Principal Financial Officer)
			/s/ MICHAEL J. SHARP
			Michael J. Sharp
			Vice President – Controller
			(Principal Accounting Officer)

 

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EXHIBIT INDEX

 

Exhibit No.		Description		Exhibits
10.		Material Contracts		10.16		Indenture dated October 3, 2003 between AAR Distribution, Inc. and iStar Garden City LLC (filed herewith).
				10.17		Lease Agreement dated October 3, 2003 between AAR Allen Services, Inc., as tenant and iStar Garden City LLC, as Landlord, and related Guaranty dated October 3, 2003 from Registrant to iStar Garden City LLC (filed herewith).
31.		Rule 13a- 14(a)/15(d)-14(a) Certifications		31.1		Section 302 Certification dated January 14, 2004 of David P. Storch, President and Chief Executive Officer of Registrant (filed herewith).
				31.2		Section 302 Certification dated January 14, 2004 of Timothy J. Romenesko, Vice President and Chief Financial Officer of Registrant (filed herewith).
32.		Section 1350 Certifications		32.1		Section 906 Certification dated January 14, 2004 of David P. Storch, President and Chief Executive Officer of Registrant (filed herewith).
				32.2		Section 906 Certification dated January 14, 2004 of Timothy J. Romenesko, Vice President and Chief Financial Officer of Registrant (filed herewith).

 

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